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Advisors and Asset Prices: A Model of the Origins of Bubbles

  • Harrison Hong
  • Jose Scheinkman
  • Wei Xiong

We develop a model of asset price bubbles based on the communication process between advisors and investors. Advisors are well-intentioned and want to maximize the welfare of their advisees (like a parent treats a child). But only some advisors understand the new technology (the tech-savvies); others do not and can only make a downward-biased recommendation (the old-fogies). While smart investors recognize the heterogeneity in advisors, naive ones mistakenly take whatever is said at face value. Tech-savvies inflate their forecasts to signal that they are not old-fogies, since more accurate information about their type improves the welfare of investors in the future. A bubble arises for a wide range of parameters, and its size is maximized when there is a mix of smart and naive investors in the economy. Our model suggests an alternative source for stock over-valuation in addition to investor overreaction to news and sell-side bias.

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Paper provided by UCLA Department of Economics in its series Levine's Bibliography with number 122247000000001003.

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Date of creation: 31 Dec 2005
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Handle: RePEc:cla:levrem:122247000000001003
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